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We downgrade Ashok Leyland (AL) shares from hold to sell with a 53% cut in our target price from R23.5 to R11. We reduce our FY15e EPS by 77%, which is driven by a reduction of 28% in truck volumes and 150 bps in Ebitda margins. AL trades at 8.5xFY15e EV/Ebitda (enterprise value/earnings before interest, taxes, depreciation, and amortisation) above its LT (long-term) average.

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We believe this is unsustainable due to (i) significantly higher competitive intensity in the next upcycle, which would constrain profitability, (ii) persistent investment in non-core areas, and (iii) high leverage (net debt/equity of 1.4x). Our forecasts remain optimisticwe imply an average Ebitda margin of 8% for the rest of FY14 (vs 1% in Q1FY14) and factor a strong revival in truck volume growth in FY15/16 (15%/25%).

FY13, the most challenging year in decade: ALs medium & heavy commercial vehicle (MHCV) franchise, accounts for 75% of the revenues. For FY13, AL reported vehicle revenues of R104 bn, engine (R4 bn), spares (R12.4 bn) and other operating income of R4 bn. It reported FY13 Ebitda of R8.76 bn and margin of 7%. Ebitda margins on its operating income would be close 80-100% as it consists primarily of scrap sales, export incentives, service income, etc. In addition, we assume margins on spares at around 20% and engines at 10%. Our assumptions imply a Ebitda margin of around 1.75% of ALs core MHCV operations.

Capex & investments significantly exceed operating cash flows: During FY10-13, AL generated R17bn cash flow from operations against a cumulative capex (capital expenditure) of R17bn and investments of R24bn. As a result, net debt has ballooned from R17bn in FY10 to R43bn in FY13. ALs net debt/equity at 1.4x is the highest ever over the last 20 years and a major cause of concern. The company has made debt reduction a key goal and expects the reduction in capex, investments and working capital to aid this process.

Investments in associates & group companies is a key investor concern: During the three-year period of FY10-13, ALs cumulative investments in group companies and associates stand at R24bn. This includes R9bn in investment companies of the Hinduja Group, R3bn in Hinduja Foundries, R1.8bn in power generation and R3bn in its JVs with Nissan. It has also invested R3-4 bn in two bus companies outside India (Avia & Optare), a construction equipment JV with John Deere, and other sundry ventures whose impact is indeterminate at this juncture.

Q1FY14: negative surprise despite expectation of a weak performance: Ashok Leylands Q1FY14 results were reflective of the weak demand environment and came in lower than our forecasts. While revenue (R23.6 bn, -21% y-o-y) was in line, Ebitda (R233m) was 26% below our estimate. The weak demand is reflected in discounts, which at R145K/vehicle was 10% of the ASP (average selling price). Ebitda margin (1%) and Ebitda is the lowest in the last decade. Reported profit was -R1.4bn vs our estimate of R-1.1bn.